The Case Against Qwest's Nacchio

December 20, 2005

He was the last major CEO connected with the telecom bust still under investigation. On Dec. 20, the feds came down on Joseph P. Nacchio. The 56-year-old former CEO of Qwest Communications (Q) was charged with 42 counts of securities fraud and insider trading. According to the eight-page indictment filed in federal court in Denver, Nacchio knew by August, 2000, that Qwest's publicly stated financial targets were extremely aggressive and meeting them would be a "huge stretch."

Yet Nacchio accelerated his personal stock sales from January through May of 2001. The government is seeking to recover the $100 million Nacchio generated from those sales. In addition, each of the charges carries a possible $1 million fine and 10 years in jail, according to documents filed at the courthouse.

SWAPPING CAPACITY. The latest indictment is the beginning of the end of a more-than-three-year saga at Qwest. In a press conference following the indictment, U.S. District Attorney William J. Leone called his investigation "substantially complete." The probe involved federal prosecutors, the Securities & Exchange Commission, and the FBI.

It was triggered by the January, 2002, release of a whistle-blower letter from a former employee of Qwest rival Global Crossing, who suggested the telecoms swapped capacity on each others' fiber-optic networks to boost sales and profit. In April, three former Global Crossing execs, also tripped up by the swaps, reached settlements with the SEC.

A Nacchio indictment has been widely anticipated. In March, the SEC charged him and six other former Qwest execs with orchestrating a massive fraud at the company. Two of those officials, Robin Szeliga, a former CFO, and Gregory M. Casey, an executive vice-president, have since agreed to settle the charges. In addition, Szeliga pleaded guilty to one criminal count of insider trading. On July 28, the judge overseeing the SEC case granted a Justice Dept. request to delay information gathering for the civil trial so the U.S. Attorney's office in Denver could continue its criminal investigation.

SHORT ON SPECIFICS. Nacchio, a New York-native who rose through the ranks at AT&T (T) before joining Qwest's predecessor company in 1997, is known as a fighter. The SEC's complaint describes him as having an "explosive temper," with one executive claiming, "people were just afraid of the man."

Nacchio has maintained that he is innocent of any improprieties at Qwest. He was due to appear in court on Dec. 20 to enter a response to the current indictment. Calls to his attorneys, former U.S. Attorney and Judge Herbert J. Stern in Nacchio's home state of New Jersey, and local counsel John Richilano in Denver were not immediately returned.

The federal indictment is short on specifics. The much longer SEC civil complaint filed in March claims that Qwest sold $3 billion worth of space on its fiber optic network to other telecom companies without disclosing the extent to which it relied on those one-time sales for revenue and profits. The complaint says Qwest's outside auditor, Arthur Andersen, requested on several occasions that the company disclose those one-time sales.

RESTATEMENTS AND FINES. Qwest employees and management called the sales "heroin" and an "addiction," because they were so necessary to meet Nacchio's ambitious growth targets on Wall Street. When the company finally reported the network sales separately from its traditional telecom service revenues in August, 2001, Qwest's stock collapsed.

The dominant local phone company in 14 Western states, Qwest narrowly averted bankruptcy three years ago. Still lumbering under $17 billion in debt taken on to build its network, its stock now trades for less than $6 a share, down from a high of $64 five years ago. Nacchio was replaced by industry veteran Richard C. Notebaert in June, 2002.

Qwest subsequently restated about $2.5 billion worth of revenue and profits and paid $250 million to settle SEC complaints about its accounting. It lost out to bigger carrier Verizon Communications (VZ) in a takeover battle for long-distance carrier MCI.

MIXED RESULTS. Proving fraud in the case against Nacchio will be no slam dunk. The U.S. Supreme Court has set a fairly broad definition for the kinds of "material" information that companies need to disclose, saying that it's anything an investor ought to know. But Nacchio argued in his response to the SEC complaint that multiple and conflicting accounting rules regard what kinds of revenue needs to be separately disclosed to investors.

That Arthur Andersen ultimately signed off on the company's financials, even after recommending disclosure of the network sales, could actually help Nacchio, lawyers say. "It only becomes a crime if you do something with intent to fraud," says Jeffrey Bornstein, a 19-year veteran of the U.S. Attorney's Office in San Francisco who is now in private practice. "If you think it's absolutely correct, how is that insider trading?"

The Justice Dept. has had mixed results so far in taking Qwest execs to court. In a 2004 trial involving accounting chicanery related to the sale of equipment to the Arizona School Facilities Board, two of the four defendants were found innocent on all charges. Two later pleaded guilty to some of the charges. Another Qwest exec, former Senior Vice-President Marc B. Weisberg, is due to go to trial in the next two weeks over charges that he illegally profited from his position by acquiring stock in Qwest partner companies before public stock sales.

ENOUGH EVIDENCE? The trouble in gaining convictions at Qwest may be why the federal prosecutors appear to have boiled the Nacchio charges down to the very basics: that he knew things weren't going well and he sold stock. The government may be looking to replicate successful legal proceedings against former WorldCom CEO Bernard Evans, Martha Stewart Living Omnimedia's (MSO) Martha Stewart, and officials at cable operator Adelphia, says Jacob Zamanksy, a securities lawyer in New York. "If you look at Bernie Ebbers, Adelphia, and Martha Stewart, the government has done an exceptional job when they keep it simple so juries understand," he says.

Testimony from former CFO Szeliga will likely be critical in a Nacchio trial. In her insider-trading plea agreement, Szeliga acknowledged that she and other senior Qwest executives knew in the first half of 2001 that the company's business units weren't meeting revenue targets and that the only way Qwest as a whole could do so was to sell more of its network capacity. She also acknowledged that this material information was deliberately withheld from investors.

Szeliga, who agreed to cooperate with the government in exchange for a reduced sentence, discussed the disclosure issue with Nacchio, according to the SEC. "It clearly strengthens the hand against Nacchio," says Jay Brown, a former SEC attorney who now teaches securities law at the University of Denver. Whether that hand is strong enough to put Nacchio behind bars will likely be decided by Colorado jurors.